Question: The relationship between financial leverage and profitability Pelican Paper, Inc., and Timberland Forest, Inc., are rivals in the manufacture of craft papers. Some financial statement values for each company for the most recent fiscal year are listed below. Use them in a ratio analysis that compares their financial leverage and profitability.
Pelican Paper, Inc.
Timberland Forest, Inc.
Total assets
$10,000,000
$10,000,000
Total equity
9,000,000
5,000,000
Total debt
1,000,000
5,000,000
Annual interest
100,000
500,000
Total sales
$25,000,000
$25,000,000
EBIT
6,250,000
6,250,000
Net income
3,690,000
3,450,000
a. Calculate the following leverage and coverage ratios for the two companies. Discuss their financial risk and ability to cover the costs in relation to each other.
(1) Debt ratio.
(2) Times interest earned.
b. Calculate the following profitability ratios for the two companies. Discuss their profitability relative to each other.
(1) Operating margin.
(2) Profit margin.
(3) Return on assets.
(4) Return on equity.
c. In what way has the larger debt of Timberland Forest made it more profitable than Pelican Paper? What are the risks that Timberland's investors undertake when they choose to purchase its stock instead of Pelican's?
(Hennessey 159-160)
Hennessey, Lawrence J. Gitman and Sean M. Principles of Corporate Finance VitalSource eBook for Athabasca University. Pearson Learning Solutions. VitalBook file.
The citation provided is a guideline. Please check each citation for accuracy before use.
Question: Integrative-Complete ratio analysis Given the following financial statements, historical ratios, and industry averages, calculate the Sterling Company's financial ratios for the most recent year. Analyze its overall financial situation from both a cross-sectional and a time-series viewpoint. Break your analysis into an evaluation of the firm's liquidity, activity, leverage, and profitability. Use a common-size analysis for profitability. Use the DuPont system to analyze ROE. Comment on the company's financial strengths and weaknesses.
Income Statement Sterling Company for the year ended December 31, 2008
Sales revenue
$10,000,000
Less: Cost of goods sold
7,500,000
Gross margin
mce_markernbsp;2,500,000
Less: Operating expenses
Selling expense
$300,000
General and administrative expenses
650,000
Lease expense
50,000
Amortization expense
200,000
Total operating expense
1,200,000
Operating earnings (EBIT)
mce_markernbsp;1,300,000
Less: Interest expense
200,000
Earnings before taxes
mce_markernbsp;1,100,000
Less: Taxes (rate = 40%)
440,000
Net income after taxes
mce_markernbsp; 660,000
Less: Preferred share dividends
50,000
Earnings available for common shareholders
mce_markernbsp; 610,000
Earnings per share (EPS)
$3.05
Balance Sheet Sterling Company December 31, 2008
Assets
Liabilities and shareholders' equity
Current assets
Current liabilities
Cash
mce_markernbsp; 200,000
Accounts payableb
mce_markernbsp; 900,000
Marketable securities
50,000
Line of credit
200,000
Accounts receivable
800,000
Accruals
100,000
Inventories
950,000
Total current liabilities
mce_markernbsp;1,200,000
Total current assets
mce_markernbsp;2,000,000
Long-term debt (includes financial leases)c
mce_markernbsp;3,000,000
Gross fixed assets (at cost)a
$12,000,000
Shareholders' equity
Less: Accumulated amortization
3,000,000
Preferred shares (25,000 shares, $2 dividend)
mce_markernbsp;1,000,000
Net fixed assets
mce_markernbsp;9,000,000
Common shares (200,000 shares)d
5,800,000
Other assets
mce_markernbsp;1,000,000
Retained earnings
1,000,000
Total assets
$12,000,000
Total shareholders' equity
mce_markernbsp;7,800,000
Total liabilities and shareholders' equity
$12,000,000
aThe firm has an 8-year financial lease requiring annual beginning-of-year payments of $50,000. Five years of the lease have yet to run.
bAnnual credit purchases of $6,200,000 were made during the year.
cThe annual principal payment on the long-term debt is $100,000.
dOn December 31, 2008, the firm's common shares closed at $27.50.
Historical and Industry Average Ratios for Sterling Company
Ratio
Actual 2006
Actual 2007
Industry average, 2008
Net working capital
$760,000
$720,000
$1,600,000
Current ratio
1.40
1.55
1.85
Quick ratio
1.00
.92
1.05
Average age of inventory
38.3 days
39.6 days
42.4 days
Average collection period
45.0 days
36.4 days
35.0 days
Average payment period
58.5 days
60.8 days
45.8 days
Total asset turnover
0.74
0.80
0.74
Debt ratio
20%
20%
30%
Costly debt ratio
10%
14%
23.9%
Debt/equity ratio
24.8%
25.2%
36.9%
Times interest earned ratio
8.2
7.3
8.0
Fixed-charge coverage ratio
4.5
4.2
4.2
Gross margin
28%
27%
27.5%
Operating margin
10%
12%
15.1%
Profit margin
7.2%
6.7%
8.9%